Xerox Corporation (XRX) is a leading global supplier of document systems, including printers, multifunctions, production publishing systems, managed print services, and software. I have received several emails asking about XRX, pointing to the fact that the company trades below book value, is profitable, and generates significant free cash flows. I thought it would be worth taking a closer look.

The printing business tends to exhibit the attractive characteristic of providing for relatively stable revenues and cash flows. This is due to the fact that many businesses in this industry generate sales from “bundled lease arrangements” in which the customer pays a single monthly price over a lease term for equipment, service, supplies and financing, plus a smaller variable component for page volumes in excess of a contractual minimum. Unlike companies that are reliant on recurring one-time product sales or signing new contracts each year, companies like XRX enjoy the fruits of their labour for many years after the customer is initially signed. This stability makes the valuation job relatively easier (at least, for this portion of the business).

Let’s begin with the company’s historical returns.

Xerox Corporation - Historical Returns, 1995 - 2010

This first chart shows relatively lackluster returns, though these might be understated as indicated by the consistent double digit cash returns. Where cash returns exceed income statement based returns metrics over a long period of time, this suggests the presence of recurring non-cash expenses. Free cash flow ultimately drives investment returns, so it is worth digging deeper even though, on most metrics returns look week.

Also worth noting is that the company’s returns on equity have been consistently above “enterprise” based figures that are based on returns to all sources of capital, suggesting significant leverage. We’ll discuss this in more detail below.

Xerox Corporation - Revenues and Margins, 1995 - 2010

This chart goes to support the contention that the company has relatively stable revenues, as a result of its annuity-like contracts. Unfortunately, we also see very little growth in the top line, which is indicative of industry maturity and the stability of the company’s market share.

In 2010 we see sudden and dramatic top line growth, but alas this is not the result of organic growth but rather a large acquisition. In February 2010, the company purchased Affiliated Computer Services, Inc. (“ACS”), a provider of business process outsourcing services. The ACS transaction was valued at approximately $8.5 billion (including $6.9 billion in cash and stock, the repayment of $1.7 billion of debt and assumption of a further $0.6 billion of debt). At the time of the transaction, ACS had a book value of $2.7 billion, though negative tangible equity of (0.64) billion. On an asset basis, this does appear quite expensive. ACS generated average free cash flow over the preceding five years of $453 million, representing a P/AvgFCF of 18.7x. So, on a cash flow basis, the acquisition still appears expensive. This suggests that XRX is highly reliant on future improvement in ACS’s fortunes in order to justify the purchase.

Let’s take a look at the company’s revenue sources and costs of each.

Xerox Corporation - Revenue Sources, 1995 - 2010

This chart shows the growing importance of services to the company’s top line, which is the result of the ACS acquisition. It also appears that ACS enjoyed lower gross margins than XRX, as we see the cost of services revenue increasing significantly in 2010 in conjunction with the ACS acquisition.

Xerox Corporation - Cash Flows, 1995 - 2010

Here’s the real meat of the argument. XRX generates sizable cash flows, and has done so relatively consistently in all years since 1999 except for 2000 and 2008. Moreover, judging by the tight coupling of cash flows from operations and free cash flows, the company has low capital demands.

Given the ACS acquisition, it is especially important to not focus on the relatively higher 2010 free cash flows and CFOs. When company A acquires company B, company A gets all of company B’s receivables, but does not have the associated cash outflows that were required to generate those receivables. As those receivables are collected, this results in a temporary boost to cash flows from operations, making this an unreliable indicator of future ability to generate cash flows. Instead, it is better to look at the consistency over a full business cycle of the company’s cash flow margins. Since 2002 (the beginning of the most recent business cycle), XRX has earned an average free cash flow margin of 9.7%, which has translated to 14.5 billion of free cash flow over the period (or $1.6 billion per year). Separately, ACS generated an average of $450 million in free cash flow over the five years prior to its acquisition. So, on a combined basis, before any synergies, the companies generated around $2 billion in free cash flow, which is quite a bit less than the 2010 figure.

Unfortunately, this is not the entire story. Not included in this chart are the significant number of acquisitions that have been made over the period. In the last five years alone, the company has paid another $3.9 billion in cash for acquisitions (though, remember the ACS transaction was largely stock and partially the assumption of debt; the sticker price of XRX’s transactions is significantly higher than this cash figure). Given the relative stability in the company’s top line and free cash flows over the period, one might draw the conclusion that these acquisitions are integral to the company’s ability to sustain its market share and operating performance, and thus actual free cash flow available to common shareholders is significantly less.

Xerox Corporation - Capital Structure, 1995 - 2010

Here we see the company’s unattractive use of debt. This is the result of the company’s business model, as touched upon above. According to the company,

Quote:We finance a large portion of our direct channel customer purchases of Xerox equipment through bundled lease agreements. We believe that financing facilitates customer acquisition of Xerox technology and enhances our value proposition while providing Xerox an attractive gross margin and a reasonable return on our investment in this business.

Because our lease contracts permit customers to pay for equipment over time rather than at the date of installation, we maintain a certain level of debt to support our investment in these lease contracts.

Though I am certainly not a fan of this debt load, I am somewhat less concerned in this case than I am for most companies. As noted by the company, the bulk of this debt is due to the financing portion of the bundled lease agreements, and is therefore “matched” to a specific and consistent revenue stream. Since the company is not reliant on any one customer, it is also likely that this debt is matched to a large number of customers, and so it is unlikely that there would be a “surprise” bankruptcy that would suddenly leave the company without a revenue stream to pay down a large amount of its debt.

So where does this leave us?

Let’s start with asset value. On an asset basis, the company is not cheap. Despite trading below book value, the company has intangibles on its balance sheet that nearly equal its book value. The bulk of these intangibles are the result of the ACS acquisition, which appears to have been accomplished at a significant premium. I see little on the asset side to justify even the current share price, let alone one significantly higher so as to create a margin of safety. On an asset basis, I’ll pass.

Turning now to cash flow. As noted, XRX and ACS have earned an average of about $2 billion of free cash flow (separately, and before synergies) on a normalized basis. The company’s enterprise value is currently about $20 billion, so this represents a free cash flow yield of just 10%. This really doesn’t excite me and my subsequent valuation shows no margin of safety at the current price. Combined with the significant debt load, lackluster returns, and the fact that management appears to have grossly overpaid for ACS (and significantly diluted shareholders in the process), I will pass on XRX. Especially when there are better opportunities in this space.

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